3 possible steps to create value

Business: Mitsui Fudosan is a Japan-based company engaged in the real estate business. It has five business segments. First, there’s the leasing unit, which is engaged in the leasing of office buildings and commercial facilities. Second, the allotment sale segment is involved in the sale of condos and houses for individual customers, as well as rental housing and office buildings for investors. There is the management segment, which includes property, brokerage and asset management. Mitsui Home is involved in new construction, reform and renewal businesses. Finally, the segment labeled “others” participates in the operation of hotels, golf courses and resort facilities, as well as the loan guarantee business.

Stock Market Value: 3.869 trillion yen (4,144.00 yen per share). The stock also trades in the U.S. as an American depositary receipt under the ticker MTSFY.

Percentage Ownership:  2.5%

Average Cost: n/a

Activist Commentary: Elliott is a very successful and astute activist investor. The firm’s team includes analysts from leading tech private equity firms, engineers, operating partners – former technology CEOs and COOs. When evaluating an investment, Elliott also hires specialty and general management consultants, expert cost analysts and industry specialists. The firm often watches companies for many years before investing and has an extensive stable of impressive board candidates. Elliott has historically focused on strategic activism in the technology sector and has been very successful with that strategy. However, over the past several years its activism group has grown and evolved, and the firm has been doing more longer-term activism and creating value from a board level at a much larger breadth of companies.

Elliott looks for three main criteria in an activist investment: (i) a high-quality business (ii) that trades at a discount to fair value and (iii) has a pathway to catalyze change and create shareholder value.

Mitsui Fudosan is certainly a high-quality business. It is Japan’s preeminent real estate company. The quality of its buildings in terms of location and rent pricing are superb. Even as a commercial real estate company, Mitsui Fudosan does possess some brand power, which translates to premium pricing power. It has such a strong brand for quality that tenants pay a premium to be in their buildings.

You do not need to do a ton of analysis to see that Mitsui Fudosan is also trading at a significant discount to fair value. Since January 2014, the company’s stock price has gone virtually nowhere. Over the same time, the Nikkei is up over 120%, and Mitsui Fudosan’s net asset value has almost tripled. The company has historically traded at a premium to its real estate value. Now it trades at a 33% post-tax discount. The value of its real estate, post-tax, is 5,700 yen per share, versus the stock trading at 3,850 yen. Plus, it has an 800-billion-yen stock portfolio, which includes a 550-billion-yen position in Oriental Land Company, or OLC, and successful fee-based real estate businesses (asset management, property management and brokerage) that brings its net asset value to 7,103 yen per share, implying an 84% discount in the price of the stock.

The sources of this underperformance are likely unsurprising to those who have been monitoring recent activist campaigns in Japan from the likes of Elliott, ValueAct and Palliser, as well as the government and Tokyo Stock Exchange’s actions in recent years. Mitsui Fudosan is grappling with a low valuation and return on equity in absolute terms and relative to peers. Shareholder confidence is only further hindered by its governance practices. Mitsui Fudosan’s 800-billion-yen stock portfolio currently accounts for about a fifth of its market cap, but significantly dilutes the company’s ROE as it generates only 7 billion yen per year in dividend income. OLC accounts for about 70% of Mitsui Fudosan’s 800-billion-yen portfolio of cross-shareholdings, which debatably could make it the company’s largest asset. This is not only an inefficient allocation of capital, but also a risky one, to have such a great share of Mitsui Fudosan’s assets in a single publicly traded company that is one of the most expensive stocks in the TOPIX 100 on both a price-earnings basis and an enterprise value to earnings before interest, taxes, depreciation and amortization basis. The Tokyo Stock Exchange has been encouraging companies to improve ROE and get above a one times book value valuation. Right now, Mitsui Fudosan has 0.65 times price to adjusted book value (for real estate companies) and the lowest ROE among its peers.

This can be remedied by a board that practices better capital allocation and corporate governance – a board that gets back investors’ confidence that shareholder return will match portfolio growth. There are three things Mitsui Fudosan can do right away to create value for shareholders. First, it can sell its stake in OLC, which it has already started doing, but given the engagement by Elliott, not at a satisfactory pace. This is somewhat like Palliser Capital’s engagement at Keisei Rail, where the firm has called for a reduction of that company’s non-core 22% stake in OLC. Second, Mitsui Fudosan can sell 500 billion yen of non-core real estate holdings. Third, the company can use the proceeds to buy back shares and invest in new real estate developments as it creates the most value by redeveloping versus holding onto these assets. This will give Mitsui Fudosan a higher return on equity, which will lead to a lower cost of capital and a higher price to book value.

This campaign is very similar to Elliott’s engagement at Dai Nippon Printing, another Japanese company, where the firm called for share repurchases to improve ROE and the accelerated disposal of certain real estate holdings and the company’s portfolio of cross-shareholdings. Shortly after the announcement of their engagement, Dai Nippon announced the largest share repurchase in its history: 300 billion yen or 30% of the company’s market cap.

Despite Mitsui Fudosan’s corporate governance situation – receiving very low governance scores from Institutional Shareholder Services, having only one-third of the board comprised of independent directors and having a strange two-year term structure – there is some optimism to be had here. There is no large controlling shareholder of Mitsui Fudosan, a relatively low amount of cross-shareholdings (approximately 8%), and current president and CEO Takashi Ueda has been vocal in his commitment to boosting shareholder returns and capital efficiency, as well as his desire to churn real estate assets.

Ken Squire is the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.